Last week Fannie Mae's board of directors released a statement responding to the findings of the Office of the Federal Housing Enterprise Oversight's (OFHEO) ongoing review of its accounting practices - putting Fannie in a bad light. Analysts said Fannie's current dilemma is not as grave as rival Freddie Mac and that the firm is expected to contest some or all of the OFHEO allegations.

In a report released last Monday to Fannie and posted on OFHEO's Web site last Thursday, it charged that for its derivatives transactions and hedging activities, the GSE applied non-GAAP compliant accounting methods and practices. Fannie also supposedly used an improper "cookie jar" reserve in accounting for amortization of deferred price adjustments under GAAP and tolerated internal control deficiencies. The regulator also accused Fannie of at least once deferring expenses, seemingly to achieve bonus compensation targets, and maintaining a corporate culture focused on stable earnings at the expense of accurate financial disclosures.

Aside from these abuses, the OFHEO added "the matters detailed in this report are serious and raised doubts concerning the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision and the overall safety and soundness of the Enterprise."

In its response released last Wednesday, Fannie said that the board is taking the report seriously and is currently working with OFHEO to resolve these matters. Aside from this, the SEC has been conducting an informal inquiry that looks at issues addressed in the OFHEO report.

Art Frank, head of mortgage research at Nomura Securities, said last Thursday that it is unclear at this point whether the results of the investigation are a negative for Fannie's debt.

Frank said that the controversy would only affect the debt markets, "if Fannie Mae restates it earnings lower to the point that it materially affects its capital." Lowered earnings could lead to Fannie having to raise more capital.

In a post-Fannie response report, Merrill Lynch analyst Rajiv Setia that the most serious issue raised revolves around derivative accounting. This most likely centers on the cash flow hedges constituting the bulk of the GSE's derivative book, Setia added. Specifically, the charge that terminated cash flow hedge mark-to-market loses are not immediately recognized.

And unlike Freddie Mac, Setia also noted that with Fannie's auditors KPMG standing behind their work, "the appropriateness of derivatives/hedge accounting will be relatively contentious."

There are two factors to keep in mind when comparing Fannie's current situation to Freddie. For one, Freddie's auditor Arthur Andersen was not present to defend its work. Also, Freddie's board of directors forced out Freddie's management at that time, Setia explained.

Separately, Banc of America Securities noted that 10-year Fannie spreads to Libor only widened roughly two basis points after Fannie's response was released. However, researchers warned that while Fannie Mae could contest some or all of OFHEO's allegations, the GSE might be forced to revise previous earnings statements and balance sheets if the charges hold up under further scrutiny. The legal implications might also make disclosure a slow process. "Furthermore, the implications for top management could be serious, given that Fannie voluntarily registered its common stock with the SEC, effective in March 2003, and in turn, began filing periodic reports to the SEC and signed off on these filings under Sarbanes-Oxley," analysts added.

Additionally, in a move to smooth earnings, the vesting terms for incentive options offered to Fannie employees might have been too specific. "It would be unfortunate if this option plan enticed Fannie to defer expenses to achieve bonus compensation targets, as OFHEO alleges," analysts wrote. "This can be the danger with some option plans."

Although analysts have more questions than answers, the GSE is expected to provide clarification as soon as possible.

At a minimum, Fannie's current troubles will provide fodder for increased regulation, stated BofA. Nothing, however, is expected to happen prior to the November Presidential election, "While stronger regulation should be beneficial for bondholders, credit analysts have mixed views on the impact of any regulation that includes receivership provisions," analysts stated.

In related news, both Freddie and Fannie released their August monthly numbers last week. Fannie showed modest numbers, reporting a slight pickup in retained portfolio commitments - by $5.1 billion to $24.7 billion. However, the growth is still historically low. Analysts from JPMorgan Securities do not predict a meaningful increase in retained portfolio growth in the near term as rising interest rates should cause liquidations to rise. The firm's duration gap widened to minus two months in August from zero months in July.

Fannie's MBS outstanding grew 7% annualized in August, which is considered rather slow but is above the recent growth trend. The firm is apparently finding more rational pricing in the private label securitization market. Analysts view this as a positive factor for the GSE's financial guarantee business.

Meanwhile, Freddie reported that its retained portfolio purchases dropped to $23.4 billion in August, from $28.7 billion in July. The firm's duration gap was zero months this month, remaining unchanged from July.

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